As part of Morningstar's "5 Days to Better Investing," we are checking in today with closed-end fund analyst Cara Esser to learn a little bit about the less-well-known closed-end fund and the role that it might play in investors' portfolios.

Thanks for joining me, Cara.

Cara Esser: Thanks for having me, Jason.

Stipp: So, the closed-end fund is similar to the mutual fund and the ETF in that it has an underlying portfolio of securities, but that may be close to where the similarities end. What are some of the key differences that investors who are looking at closed-end funds should think about?

Esser: The biggest difference between a closed-end fund, a mutual fund, and an ETF is a fact that it's closed. The closed-end fund has an IPO just like a stock, and if you would like to buy shares, you have to buy them on the secondary market from another investor. So unlike a mutual fund that you can just put money in and pull it out whenever you want from the manager, you can't do that with a closed-end fund. So, because of the secondary market trading, this gives rise to discounts and premiums. So, this means that a fund's share price may or may not equal its net asset value, which typically it does not, actually, equal the net asset value.

The second biggest difference for closed-end funds, again, because they're closed, these funds can use leverage. So, ... the most common types of leverage are debt and preferred shares. So, borrowing money from a bank or issuing preferred shares, and then using the money to invest in even more assets. So, hopefully, if the market's going up, you are generating more income and more capital gains than you would otherwise, but it also works on the other end, and if the market is going down, the closed-end fund that is leveraged will most likely be hurt more than a fund that does not use leverage.

Stipp: So, that can cut both ways.

So, you mentioned a couple of different dynamics that arose out of the fact that the fund is closed. So, given that there is a different structure here and you can see different effects and different ways that the closed-end fund might perform, what sorts of investments would the closed-end fund structure be good for?

Esser: The closed-end fund structure is very good for income-oriented investors. About 70% of all closed-end funds are actually fixed-income oriented strategies. So, the average closed-end fund that invests in a fixed-income strategy has a 7% distribution rate based on its net asset value, which is fairly high. So these funds..

Stipp: ... And is that juiced by the leverage in some cases?

Esser: Yes, so these funds mostly do use leverage, which is obviously helping the distribution rate, but they also are legally bound to distribute most of the income and capital gains that they earn each year. So, as long as they are earning income and capital gains, they have to distribute it, which is really sort of why the closed-end funds get their reputation for being good for income.

Stipp: And I know that one of the problems that sometimes open-end fund managers have is that when the market turns against them, they have these redemptions that can really cause them a lot of pain because they are selling things they might not want to otherwise sell. But the closed-end fund actually doesn't have that problem to that extent because of the closed structure.

Esser: Exactly. We saw that it sort of helped, I guess, during the 2008 market crash. However, you had the leverage on top of this. So, the leverage actually was bad for a lot of the funds during that time period, but overall leverage can be fairly positive. But [in closed-end funds] you don't have a redemption; you don't have to run on the funds. And you also don't have, when times are going great, you don't have a rush of money into the fund where the managers are having to buy shares at overvalued prices, because they have to put the money somewhere.

Stipp: So, would this make the closed-end fund good for certain illiquid areas of the market because of that?

Esser: It's especially good for illiquid areas of the market. We have a lot of closed-end funds that invest in sovereign debt of Asian countries, for example, or China A shares, which is a difficult to class to get into. Also, municipal bonds, which are fairly illiquid, about 40% of all closed-end funds are municipal bond fund. So, there is a large access to those kinds of markets in closed-end funds.

Stipp: Okay, so you mentioned earlier a little bit about the discount-premium dynamics. So, as I'm looking across closed-end funds as an investor, I might be tempted to find those funds that have the biggest discount, because it looks like I'm really getting these assets at a good price. But the story is really much more complicated than that.

Esser: It is. When you are looking at discounts, you should look at relative discounts and not just absolute discounts. So, a good example would be if a fund is trading at a 10% discount. On an absolute basis, that sounds pretty good. I can get a 10% discount on my net assets.

But if the reality is, historically this fund is selling at a 15% discount, well my 10% discount doesn't look so good anymore. So, you need to be sure that you look at the trends in the discount. How long has it been selling at this discount? What are average discounts over a long time period? We look at typically one year and three years just to gauge what's a reasonable range for the discount, and is it outside of that range. And that's when you can make a decision based on the discount and premium.

Stipp: It sounds like what you are saying is that these discounts can, in some cases, persist for a long time. Why is that? Why would a closed-end fund sell at a discount when the assets, when you add them up in that portfolio, would be worth more?

Esser: Well, the answer has been looked at by many academics, and there are all kinds of theories as to why this happens. No one knows for sure, but an investor should just be aware that the discounts persist, they're there, they happen, and you need to not just buy it because of the discount. Put it into some context so you can see relative to historical averages, where this discount is.

Stipp: To see in context how big or how small is the discount.

So, you also mentioned how these funds are popular with income investors and how the leverage can sometimes juice the income that investors can get from them.

So, as an investor, again, I think, especially in the low-yield environment like we have right now, I might be tempting to look for that highest-yielding closed-end fund because I'm going to finally get some income out of some kind of investment. But again, this is not the whole story. This is not where investors should end their research.

Esser: That's exactly right. In the closed-end fund world, we actually called yield the distribution rate, because the distribution can come from three different areas. We have income, which is just income from interest on bonds from the underlying holdings. You have dividends from stocks in the underlying portfolio. You have capital gains, which is, obviously, if the value of your underlying portfolio increases, that's a capital gain. And then the third is return of capital.

Return of capital is a fairly complicated topic and also a very heated topic, but the gist of return of capital is that there are two types; there is constructive and destructive. Constructive return of capital would be if the fund's net asset value during a certain period actually increased, even though the fund was distributing capital, so here is an easy example.

During the fiscal year, the fund's net asset value went up by $2, and the fund distributed $0.50 in return of capital. Well, we would say that's constructive return of capital, because the fund is most likely holding on to stocks, or fixed income, that they think are still going to appreciate, instead of selling them simply to meet the distribution--which we don't want them to do that, either, because that's hurting the long-term value of the portfolio, selling just to meet the distribution.

And destructive return of capital is just the opposite. So, if during the fiscal year, the net asset value fell by $2 and they distributed the same $0.50 in return of capital, we would say that's destructive return of capital, because it's actually eating away the net asset value and that's bad for longer-term shareholder value.

Stipp: So, you really need to dig in and understand exactly where that income is coming from to understand if it's high-quality and something that you think would be sustainable.

So, this leads to my final question, which is, it sounds like the management has some flexibility here in running the fund, and that stewardship probably is a big issue with closed-end funds.

So, what are some of the hallmarks that you would look for to know that a fund is well-managed for shareholders' best interest?

Esser: Well, a closed-end fund is a little bit unique in that it has a board of directors that makes most of the non-portfolio decisions on behalf of shareholders. So, anything that has to do with the distribution or the discounts, anything that they want to do to manage the discount, or even firing the managers of the portfolio, that's the board of directors. So, it's important to understand the board of directors, and to understand the role that they play.

We like to see boards that are active, that actually do things to mitigate these discount and premium problems or to increase or decrease a distribution rate when it's appropriate, and it's easy to find those funds, because all you have to do is look at some press releases and see how active has the company been and the board been in the last year with any of their funds, because they don't have to be active in the specific fund, but if they're active in funds that actually need work, it's a good place to start.

Stewardship also comes from the parent company. They are the ones that are making the overall decisions and setting the behavior patterns of everybody in the company. So, we like to look at websites and just kind of see how is transparency? Are they providing information for investors in an easy to understand, easy to read timely manner?

And finally the managers obviously play a very big role in this. We actually talk to the managers and try to get an understanding of their strategy, and do they have a handle on their strategy and how they implement it.

Now this is more difficult for individuals to obviously do. They're not talking to managers. But one thing that you can do is read the annual report, because most of the time the managers will include at least a little discussion of what happened during the year.

In addition, you can simply look at the top holdings, and where the portfolio is positioned. Does it match the strategy that they say they're following? Because in the end, you're buying a strategy, so they invest in a certain way, and are they doing that or are they not doing that?

Stipp: All right, Cara. Some really interesting, helpful tips, and some interesting insights on this lesser-known investment type. Thanks for joining me.